Individuals purchase insurance products to provide financial security in the event of accidental property damage to their homes, automobiles and other non-financial assets. For example, in purchasing a standard homeowners policy, an individual homeowner pays an insurance premium in exchange for an insurance policy that provides compensation for accidental losses or damage to the individual's residence caused by such events as fire, wind damage, and other events causing structural damage.
Businesses typically purchase property and casualty (“P&C”) insurance products to insure against financial losses in the instance of accidental property damage as well as against other liabilities. Consequently, there are a variety of different types of P&C insurance products available for individuals and companies to purchase to provide protection from a loss.
In general, the less risk is entailed in insuring a given property, the cheaper it is to obtain P&C insurance. Conversely, it is more expensive for an individual or business to purchase these types of policies for a property facing a higher risk of damage. This is a direct result of the fact that the premium payments of insurance products are directly related to the likelihood and severity of a loss. Typically, insurers utilize actuarial data to determine the risks entailed in insuring a given property. The insurer utilizes this data as a key input in determining an appropriate premium amount to charge the policyholder.
However, in the case of low frequency and high severity catastrophe events (events that are sufficiently wide in scope to impact a large number of policyholders at one time), traditional data may not sufficiently account for the risk of certain catastrophic events that could inflict damage to a property and, hence, losses to the properties underlying insurance policy. Examples include war, hurricanes, earthquakes, floods, tornadoes, terrorism, etc. These events, which have devastating effects, are difficult to predict with any degree of accuracy. Accordingly, insurers bear additional risks.
In an effort to ameliorate the effects of this additional risk, insurers utilize a variety of different techniques to manage and finance these risks. For example, insurers often utilize exposure limits and strict underwriting standards to control the overall magnitude of the risk at the insurance company. At the same time, insurers use a variety of methods to finance the catastrophe risks that remain, including traditional reinsurance, risk-linked securities, debt, equity, and hybrid capital structures. Reinsurance is a means by which an insurance company (“cedant” or “ceding insurer”) can protect itself against the risk of loss on underlying insurance policies by transferring a portion of the risk on these policies, along with a reinsurance premium, to another insurer (“reinsurance company”). Reinsurers, in short, provide insurance to insurance companies.
There are many reasons an insurance company will choose to utilize reinsurance as part of its responsibility to manage a portfolio of risks for the benefit of its policyholders and investors. The main use of reinsurance is to allow the ceding company to protect the solvency of the company against an accumulation of claims associated with a catastrophic event—ensuring that policyholders can be repaid after a large loss. Reinsurance can improve an insurance company's balance sheet by reducing the amount of net liability, and thereby increasing surplus. Surplus, assets less liabilities, is roughly the same as shareholder equity on a balance sheet of a non-insurance company.
There are several types of reinsurance. Proportional reinsurance involves one or more reinsurers taking a stated percent share of each policy that an insurer produces (“writes”). This means that the reinsurer will receive that stated percentage of each dollar of premiums and will pay that percentage of each dollar of losses.
Proportional reinsurance may have a variety of implementations. One such implementation is known as the quota share structure. When a quota share structure is used, the reinsurer assumes responsibility for a predetermined percentage of the benefit amount, rather than a predetermined amount. In exchange, the reinsurer receives a predetermined percentage of the premiums and losses received by the primary insurance provider. Thus, the primary insurer will experience an increase in the net amount of retained commission, since the decrease in capital is less than the decrease in liability.
Another implementation of proportional reinsurance is known as the surplus share structure. Under the surplus share structure, the reinsurer bares responsibility for risk based on a variable percentage rate above the insurer's retention limit, but no more than a predefined amount. The insurer receives a commission for an agreed upon share in the received premium. The amount retained by the primary insurer is referred to as a line and is defined in terms of a specific amount. Under the surplus share structure, the reinsurer and primary insurer share based on a predetermined percentage basis, any exposure which is greater than the retention limit of the primary insurer. The divisions of both premiums and liability between the primary insurer and reinsurer are based on a variable percentage for the entire portfolio; this is because a distinct retention amount may be chosen for each policy.
Non-proportional reinsurance, also known as excess of loss reinsurance, only responds if the loss suffered by the insurer exceeds a certain amount, called the retention. An example of this form of reinsurance is where the insurer is prepared to accept a loss of $1 million for any loss which may occur and purchases a layer of reinsurance of $4 m in excess of $1 million—if a loss of $3 million occurs the insurer pays the $3 million to the insured(s), and then recovers $2 million from their reinsurer(s). In this example, the insurer will retain any loss exceeding $5 million unless they have purchased a further excess layer (second layer) of say $10 million excess of $5 million.
However, with limited capacity to provide such coverage in the traditional reinsurance market, primary insurance companies have increasingly turned to an alternative to traditional reinsurance for financing the risk of large catastrophe losses—the transfer of the risk directly to capital market investors through the risk-linked securities market.
Traditional catastrophe excess of loss reinsurance policies typically cover several underlying risks or “perils” (e.g., hurricane, earthquake, etc.), but only provide cover on a single event or per occurrence basis, whereby the reinsurance provides compensation for 1 (2 if the reinsurance includes a reinstatement provision) individual loss events and not an accumulation of multiple loss events. Considerably less common is a form of catastrophe reinsurance known as aggregate annual excess of loss catastrophe reinsurance where the policy provides compensation for an accumulation of events during the course of a calendar year.
In purchasing a reinsurance policy, a ceding insurance company is purchasing a promise by the reinsurance company to compensate the insurer for losses sustained in the aftermath of a catastrophic event. For extremely large losses, however, the same events that give rise to solvency concerns at primary insurance companies, and caused the company to consider purchasing reinsurance, can stress the payment capacity of reinsurance companies. As a result, primary insurance companies have increasingly turned to an alternative to traditional reinsurance for financing the risk of large catastrophe losses—the transfer of the risk directly to capital market investors through the risk-linked securities market.
In a risk-linked securities transaction, the primary insurance company cedes catastrophe risk to a special purpose reinsurance company in a similar form as a traditional excess-of-loss reinsurance contract. In contrast to traditional reinsurance, however, the special purpose reinsurance company finances 100% of the risk embedded in the reinsurance contract through the issuance of bonds (“catastrophe bonds”) to qualified institutional investors or buyers (“QIBs”). In return for their investment of principal, which remains at risk to pay losses under the reinsurance contract during the coverage period, investors earn an interest rate equal to the London Interbank Offer Rate (Libor) plus the rate-on-line on the reinsurance coverage. The investment of principal, which equals the coverage limit provided to the ceding insurer, is deposited in a trust to collateralize the reinsurance provided to the ceding insurance company—ensuring that funds are available to the ceding insurer should an event create a loss under the reinsurance transaction. As a result, the ceding insurer purchases an excess-of-loss reinsurance contract without the credit risk associated with a traditional reinsurance contract.
The first risk-linked security transactions in the property-casualty industry date back to the mid-1990s, when several insurance companies issued “Act-of-God” bonds. (See for example, Lewis and Davis (1998), “Capital Market Instruments for Financing Catastrophe Risk: New Directions”, Journal of Insurance Regulation, Winter 1998 (17, 2), pps. 110-133. Moreover, the securitization of insurance risks has followed the development of securitization structures (e.g. program shelf structures) in other markets. See for example, Cummins, J. David and Christopher M. Lewis, Securitized Risk Instruments as Alternative Pension Fund Investments,” in ed. Mitchell, Olivia and Kent Smetters, The Pension Challenge: Risk Transfers and Retirement Income Security, Pension Research Council, Oxford University Press, December 2003.)